Financial Terms

Sourav Saha
Master of International Business Department of Commerce Delhi School of Economics University of Delhi

PERPETUAL BONDS
What are Perpetual Bonds? Perpetual bonds are bonds that dont have a maturity date, and to compensate for the fact that investors can never redeem them they pay a higher rate than other bonds with a similar credit profile. Perpetual bonds are not redeemable but pay a steady stream of interest forever. Their cash flows are therefore that of perpetuity. Perpetual bonds are those in which the investor does not have an option to ask for the money back. (But in some cases, the issuers have the right to payback the investors and redeem the bonds after a period of time). A perpetual bond is colloquially known as a Perpetual or just a Perp. As with any bond issue, it is possible for an investor to sell a perpetual bond if he or she wishes to do so, transferring all rights to future profits to the new bond owner. Therefore, it may be treated as equity, not as debt. They are supposed to be listed on the stock exchange also, but there is no trading in them at all. While this may be of interest to pension funds and institutional investors, there is no value in this for retail investors. These bonds are good for banks and other companies to raise money and shore up their capital and also good for pension funds who would like to lock on to the high interest rates, and if they got the principal redeemed then they anyway need to reinvest it in another instrument. The most famous of these are the UK Consols, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today. Some ultra-long-term bonds (sometimes a bond can last centuries: Weat Shore Railroad issued a bond which matures in 2361 AD, i.e., 24th century) are sometimes viewed as perpetuities from a financial point of view, with the current value of principal near zero. Pricing of Perpetual Bonds Since perpetual bond payments are similar to stock dividend payments - as they both offer some sort of return for an indefinite period of time - it is logical that they would be priced the same way. The price of a perpetual bond is therefore the fixed interest payment, or coupon amount, divided by some constant discount rate, which represents the speed at which money loses value over time (partly because of inflation). The discount rate denominator reduces the real value of the nominally fixed coupon amounts over time, eventually making this value equal zero. As such, perpetual bonds, even though they pay interest forever, can be assigned a finite value, which in turn represents their price. The basic perpetual bond formula includes a fixed coupon amount that is in turn divided by a discount rate that is predetermined to account in part for economic inflation. This helps to put a cap on the value of the bond over time, even though the return on the bond issue is in the form of interest. Perpetual bonds are valued using the formula: i/y where, i is Annual Coupon Interest on a bond and y is an expected yield for maximum term available.

The argument to buy perps hinges on three things: absolute yield, rates direction and your bet on the company calling them or not at the call date. As with most types of bond issues, a perpetual bond tends to be a relatively stable investment that will continue to provide small amounts of profit for as long as the bond is active. This makes the bond an attractive option for investors who tend to be very conservative. However, a perpetual bond is never likely to yield a huge profit in a short period of time, characteristic that will turn off investors who are more willing to assume risk in return for the chance to realize a higher return. Risk Associated with Perpetual Bonds Banks, Reserve Bank of India, institutional investors - all agree that perpetual bonds carry bigger risk, for investors, than subordinated bonds. But that has not stopped credit rating agencies from offering hybrid capital the same rating as that for subordinated debt issued by the banks. RBI has put a caveat that such hybrid securities will cease to provide returns if the issuing bank's CRAR falls below regulatory requirements (at present nine per cent).This makes perpetual debt instruments a risky option for investors, particularly in those banks where the CRAR is at lower levels. What is thus, prima facie palpable is the fact that the 'innovative' instruments hold good only for those banks that have a high credit rating and good asset quality. Else, convincing investors about the security of their capital or garnering the perpetual debts at feasible interest rates will prove to be a complex barrier for banks' capital expansion. The RBI evidently has thus ensured that while deserving banks have sufficient leeway to fund their growth, the inept ones either shape up or ship out, aver some analysts. As of now, these perpetual bonds do not carry any tax incentives.

FREE FLOAT CAPITALIZATION METHODOLOGY

What is Free Float Capitalization Methodology? Free-float Methodology refers to an index construction methodology that takes into consideration only the free-float market capitalization of a company for the purpose of index calculation and assigning weight to stocks in the Index. Free-float market capitalization takes into consideration only those shares issued by the company that are readily available for trading in the market. It generally excludes promoters' holding, government holding, strategic holding and other locked-in shares that will not come to the market for trading in the normal course. In other words, the market capitalization of each company in a Free-float index is reduced to the extent of its readily available shares in the market. A method by which the market capitalization of an index's underlying companies is calculated. Free-float methodology market capitalization is calculated by taking the equity's price and multiplying it by the number of shares readily available in the market. Instead of using all of the shares outstanding like the full-market capitalization method, the free-float method excludes locked-in shares such as those held by promoters and governments. How to calculate FFM It is calculated as: FFM = Share Price X (Shares Outstanding Locked In Shares) The free-float method is seen as a better way of calculating market capitalization because it provides a more accurate reflection of market movements. When using a free-float methodology, the resulting market capitalization is smaller than what would result from a full-market capitalization method. Shareholdings of investors that would not, in the normal course, come into the open market for trading are treated as 'Controlling/ Strategic Holdings' and hence not included in freefloat. Specifically, the following categories of holding are generally excluded from the definition of Free-float: Shares held by founders/directors/acquirers which has control element Shares held by persons/ bodies with "Controlling Interest" Shares held by Government as promoter/acquirer Holdings through the FDI Route Strategic stakes by private corporate bodies/ individuals Equity held by associate/group companies (cross-holdings) Equity held by Employee Welfare Trusts Locked-in shares and shares which would not be sold in the open market in normal course.

Free-float methodology has been adopted by most of the world's major indexes, including the Dow Jones Industrial Average and the S&P 500.

All BSE indices with the exception of BSE PSU index have adopted the free-float methodology. Major Advantages of Free-float Methodology A Free-float index reflects the market trends more rationally as it takes into consideration only those shares that are available for trading in the market. Free-float Methodology makes the index more broad-based by reducing the concentration of top few companies in Index. A Free-float index aids both active and passive investing styles. It aids active managers by enabling them to benchmark their fund returns vis--vis an investible index. This enables an apple-to-apple comparison thereby facilitating better evaluation of performance of active managers. Being a perfectly replicable portfolio of stocks, a Free-float adjusted index is best suited for the passive managers as it enables them to track the index with the least tracking error. Free-float Methodology improves index flexibility in terms of including any stock from the universe of listed stocks. This improves market coverage and sector coverage of the index. For example, under a full-market capitalization methodology, companies with large market capitalization and low free-float cannot generally be included in the Index because they tend to distort the index by having an undue influence on the index movement. However, under the free-float Methodology, since only the free-float market capitalization of each company is considered for index calculation, it becomes possible to include such closely held companies in the index while at the same time preventing their undue influence on the index movement. Globally, the free-float Methodology of index construction is considered to be an industry best practice and all major index providers like MSCI, FTSE, S&P and STOXX have adopted the same. MSCI, a leading global index provider, shifted all its indices to the Free-float Methodology in 2002. The MSCI India Standard Index, which is followed by Foreign Institutional Investors (FIIs) to track Indian equities, is also based on the Free-float Methodology. NASDAQ-100, the underlying index to the famous Exchange Traded Fund (ETF) - QQQ is based on the Free-float Methodology.

BETA FACTOR
What is the Beta Factor? Risk is an important consideration in holding any portfolio. The risk in holding securities is generally associated with the possibility that realised returns will be less than the returns expected. Risks can be classified as Systematic risks and Unsystematic risks. Unsystematic risks: These are risks that are unique to a firm or industry. Factors such as management capability, consumer preferences, labour, etc. contribute to unsystematic risks. Unsystematic risks are controllable by nature and can be considerably reduced by sufficiently diversifying one's portfolio. Systematic risks: These are risks associated with the economic, political, sociological and other macro-level changes. They affect the entire market as a whole and cannot be controlled or eliminated merely by diversifying one's portfolio. The degree, to which different portfolios are affected by these systematic risks as compared to the effect on the market as a whole, is different and is measured by Beta. To put it differently, the systematic risks of various securities differ due to their relationships with the market. The Beta factor describes the movement in a stock's or a portfolio's returns in relation to that of the market return. For all practical purposes, the market returns are measured by the returns on the index (Nifty, Mid-cap etc.), since the index is a good reflector of the market. It is also known as the Beta Coefficient. It measures the part of the asset's statistical variance that cannot be removed by the diversification provided by the portfolio of many risky assets, because of the correlation of its returns with the returns of the other assets that are in the portfolio. Beta can be estimated for individual companies using regression analysis against a stock market index. Beta is calculated using regression analysis, and you can think of beta as the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with the market. A beta" of less than 1 means, that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market. Many utilities stocks have a beta of less than 1. Conversely, most high-tech, Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk.

How to Calculate Beta Beta is calculated as: = Cov (X,Y) / Var (X)

where,

Y is the returns on your portfolio or stock - DEPENDENT VARIABLE X is the market returns or index - INDEPENDENT VARIABLE

Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset's returns to market returns, its nondiversifiable risk, its systematic risk, or market risk. On an individual asset level, measuring beta can give clues to volatility and liquidity in the marketplace. In fund management, measuring beta is thought to separate a manager's skill from his or her willingness to take risk.